Cash-out refis are key to near-term extension risk

As interest rates rise and cash-out refinance volumes drop significantly, discount speeds will be the first to be suppressed, researchers noted.

Credit Suisse First Boston analysts expect annualized cash-out volume to drop to $135 billion, the lowest levels since 2000, should mortgage rates rise to 6.90%. Freddie Mac estimates there will be an additional $40 billion in home equity extraction over this quarter, reaching $204 billion for 2005, the second highest year on record after $225 billion of cash-out activity in 2002. However, 2006 equity extraction will probably be cut in half to $114 billion, Freddie Mac estimates.

In this month's Short-Term Prepayment Estimates, Bear Stearns analysts enumerated a variety of factors likely to drive prepayment speeds slower even after factoring for recent interest rate hikes, the most important of which is the decreasing economic incentive to cash out.

The lack of attractive cash-out opportunities greatly impacts Bear Stearns' short-term prepayment expectations. Cash-out activity has been the biggest driver of fast speeds in the 6% and 5.50% coupon sectors versus similar past periods, Bear analysts note. There is empirical evidence that once a coupon moves out of the money by more than 50 basis points, the cash-out prepay contribution to the coupon drops off considerably. Bear analysts estimate that in the last three months, cash-out refinancing has contributed an added 1.1, 5.2, and 7.4 CPR to the 4.50%, 5%, and 5.50% coupons, respectively, versus equivalent coupons in 1999 to 2000.

Thus, with the mortgage universe moving through the par minus 50 basis point exposure threshold - currently 42 basis points below par - analysts expect the cash-out contribution to prepayments to significantly weaken. This makes sense for borrowers since first-lien home equity extractions using an amortizing mortgage option generally becomes much less attractive at this level, added analysts. For instance, the average 30-year borrower looking to cash-out today is unlikely to move into a standard 30-year loan since both the rate and monthly payment would rise significantly. By contrast, 5/1 hybrid loans still offer a slight rate and monthly payment savings at current interest rates.

Analysts said that as the market exposure drifts below this threshold, cash-out borrowers are increasingly forced into the non-amortizing or option ARM products to keep monthly payments low. This typically leads borrowers to second liens or HELOCs as an alternative to a first-lien refinancing. Although, with the flatter yield curve, these prime-rate based options have become much less attractive as well. For instance, the average HELOC rate is now 6.50%. Bear analysts also noted that if a borrower takes out a second lien, there is no first lien prepayment as in a cash-out refinancing.

Based on 3Q05 refinancing economics - 72% of Freddie Mac refinance transactions were cash-outs with an average 57 basis point rate reduction - borrowers now face a far less advantageous cash-out environment, Bear analysts concluded. The 5.50% coupon (where speeds have been running over 20 CPR for four straight months) is most at risk for a considerable drop in cash-out prepayments. Analysts expect 5.50% coupon prepayments to dip between 12 CPR to 13 CPR by January.